Nixing 'Mark to Market' Won't Solve the Problem 12 comments
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I am a little confused. How will removing the mark-to-market accounting rule, an idea that is rapidly gaining traction, help solve the problem? If balance sheets are not prepared with market prices, it will allow companies to arbitrarily assign a price to the illiquid assets it holds. What kind of price are they going to select? Obviously, a high one!
To me, this will just lend less credibility to bank balance sheets because investors will assume the banks are choosing artificially high prices for the assets they get to assign values to. Will sovereign wealth funds, private equity funds, and hedge funds all of a sudden start to offer new capital injections into firms that are doing this? I highly doubt it.
One reason why WaMu (WM), Wachovia (WB), and Lehman Brothers (LEH) went under was because nobody trusted their balance sheets enough to invest in them. Marking up those toxic assets arbitrarily would hardly result in more confidence than there is today.
Full Disclosure: No position in any of the companies mentioned at the time of writing.
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This article has 12 comments:
While mark to market works fine in a market that is stable, it works terribly in a market that is unstable. It forces banks to value and sell assets at the lowest sales prices conducted by their weakest competitors. Given they too are then forced to sell, it puts artificial downward pressure on the asset. The potential buyers also know this, so they sit back and wait for an even lower price before they agree to a deal. This continues and before you know it, mortgage backed securities are selling for .22 on the dollar. It's an artificial situation being caused by the rule. It doesn't relieve the problems, but does relieve the critical nature of this crisis.
Our banks have faced crisis before, but never with the mark to market rule. They survived previously, but won't if we continue with current law.
On a hold to maturity basis (see John Mauldin's analysis, for example), then there is a compelling case to be made that the assets are materially undervalued. Rescinding FAS 157 might make some institutions no longer technically insolvent, and this by itself could do a great deal to resolve some of the counterparty risk in short term lending that has devastated the credit markets.
Perhaps more importantly, rescinding FAS 157 would cost the US taxpayer quite a bit less than $700B.
The bailout plan is a viable solution as the government would be able to purchase many of these loans, and can then sit on it until the economy improves. This way, Banks would benefit, and would be able to continue doing business by lending money to all the avg Joes and their businesses on a day to day basis. He, in turn, would survive and continue paying his mortgage, paying bills and living his life in general. The trickle down effect would at least help sustain our weakened economy from becoming weaker.
My suggestion is this: The banks should separate the mortgages they own into 3 groups and value them separately. (1) mortgages they want to hold until maturities, (2) mortgages they know are bad and should be written off, and (3) questionable mortgages that they want to sell. Then, we create an exchange to trade such mortgages. The global investors are smart enough to value the questionable mortgages in an open exchange condition. Now, the banks can either sell the mortgages or market them to the market.
When you have the public distrusting the balance sheet, no amount of mark to model numbers will help you. See also: Enron.
It's amazing the positives that can flow from a little market adversity.
Following a particularly savage kicking from Wall Street, a chastened Congress appears to have "discovered" the logic of the US Treasury's Troubled Assets Relief Program.
At the same time, in a move that could considerably boost TARP's effectiveness, the Financial Accounting Standards Board (FASB) and the US Securities and Exchange Commission have embarked on a timely "interpretive" review of the much-maligned "fair value accounting" rule.
This move to capture more of the spirit, rather than simply the letter, of the law opens the door to a more expansive representation of banking sector balance sheets.
Fair value, or mark-to-market, accounting has proved a major killer for global credit markets over the life of the sub-prime crisis. This approach to asset valuation calls for companies to assess a disposal price of financial assets "at the measurement date" and not the potential value of the asset at some future date.
This may have been logical in a stable market, but when asset values are in retreat and a majority of holders become potential sellers, then the "at the measurement date" requirement has forced accountants to gravitate towards what in essence are fire sale valuations. This is particularly so when the assets in question are over-the-counter obligations that do not trade in a liquid marketplace, such as issuer-sponsored residential mortgage-backed securities, or the collateralised debt obligations that they spawned.
The result has been a seemingly self-fulfilling spiral lower in the asset values underpinning financial market balance sheets. Write-downs have at best led to significant contraction in the supply of credit. At worst they've precipitated full-scale corporate collapse.
Over recent weeks I've discussed the "duration" logic behind TARP - its capacity in the short term to soak up distressed assets from banks with a view to retaining them, long term, for "orderly realisation".
This in effect points to a Treasury arbitrage of FASB's fair value rule, as it would see assets acquired approaching fire sale book value then disposed of at valuations that would apply in an orderly market.
This distinction highlights why any change to mark-to-market accounting is so important. Whether through its scrapping or through a less draconian interpretation, the banking sector would immediately face the prospect of a round of positive financial asset revaluations.
Balance sheets would be boosted. System lending capacity would be lifted. Ultimately, the unfolding credit squeeze would be eased.
Given these are the very goals that TARP is aimed at achieving, were it to be implemented in conjunction with a change to fair value accounting rules, its task would overnight become a whole lot easier. In effect, $US700 billion ($840 billion) of acquisition capacity would deliver far greater bang for the buck.
Even if it meant relying upon a more flexible interpretation, rather than a wholesale rescinding, of FASB fair value accounting statement 157, this sounds like a logical win for legislators.
On Tuesday FASB issued "clarifications" aimed at delivering a looser application of existing rules. In particular, it encouraged companies to rely on their own judgements in determining asset values, including "expectations of future cash flows" from an asset, so long as appropriate risk premium had been applied.
This opened the door to "present value" assessments, which could prove radically higher than "at the measurement date" valuations.
The FASB statement also suggested alternative means of looking beyond the "temporary impairment pricing" that results from "disorderly" market disposals.
Given impaired value write-downs have been a key feature of many of the substantial losses that have been booked by investment banks over recent months, this could prove a major concession.
Using mark-to-market for loans leads readers of financial statements to thinking they are looking at the "real value" of those loans when nothing could be further from the truth. There is no market right now for some of these loan products. But companies that have no intention of ever selling a loan are expected to come up with a market value for it.
Can anyone deny that banks have been subjected to bank runs precipitated by those adverse values? WMs option ARMS loans didn't cause its demise. The FDIC takeover was attributed to a deposit run. That deposit run was caused by a flood of bad publicity, and frankly, made up numbers, about loan portfolio values.
For you mark-to-market adherents, why don't we mark all property to market? I was a financial executive in the airline industry for many years. I once sold 10 airplanes that our company had used extensively for almost 3 times what we had originally paid for them 15 years before. We recorded a big gain. Why didn't that company have to mark those assets to market long before that sale?There was a much more well-known market for those assets then there is for mortgage loans today.